Get Ready for the New Investment Tax

Taxes may not be fun to talk about but this new tax starts in 2013 and that is coming fast.

**A version of this article appeared June 30, 2012, on page B7 in the U.S. edition of The Wall Street Journal, with the headline: Get Ready for the New Investment Tax, as well as the WSJ.com online edition. A condensed version is provided here.

Get Ready for the New Investment Tax

Investors were waiting to see what the Supreme Court would do about the 3.8% surtax on investment income, part of President Obama’s health-care overhaul. The Internal Revenue Service hasn’t yet released guidance on the new tax.

The new tax, which Congress passed in 2010, affects the net investment income of most joint filers with adjusted gross income of more than $250,000 ($200,000 for single filers). Starting on Jan. 1, 2013, the tax rates on long-term capital gains and dividends for these earners will jump from their current historic low of 15% to 18.8%, assuming Congress extends the current law.

If, on the other hand, Congress allows the tax rates set in 2001 and 2003 to expire on Dec. 31—an unlikely scenario, according to many experts—the top rate on capital gains will rise to 23.8% and the top rate on dividends will nearly triple, to 43.4%.

The health law’s future depends on which party controls the White House and Congress after elections in November.

The new levy’s ramifications extend far beyond the end of the year, however, and will be a game changer for many taxpayers. In the future, affluent investors will need to manage both their adjusted gross income and their investment income in order to minimize this tax, says CPA Dave Kautter of American University’s Kogod Tax Center.

“This [3.8%] tax alone makes accelerating investment income into 2012 profitable for many taxpayers,” says Robert Gordon of Twenty-First Securities, a tax-strategy firm in New York.

Also attractive for the same reasons: Roth individual retirement accounts, which differ from regular IRAs in that withdrawals are tax-free. “I’m telling my clients who have been considering converting from a regular IRA to a Roth IRA, ‘Do it now,'” Mr. Horn says.

Others will turn to traditional defined-benefit pension plans. Older taxpayers who are eligible to set up such a plan for themselves—for example, because they have income from a business—can take large deductions that reduce their adjusted gross income. Payouts from such plans aren’t subject to the 3.8% tax, although they do swell income in a way that could help trigger the tax on other investment income.

Here are answers to some basic questions about the tax. For more detail, consult a tax professional—but give it a few weeks so that he or she can get fully up to speed:

How does the 3.8% tax on investment income work?

It applies to most joint filers with adjusted gross income above $250,000 and single filers with adjusted gross income above $200,000.

Adjusted gross income is the number at the bottom of the front page of form 1040; it includes interest, dividends, capital gains, wages and retirement income plus results from partnerships and small businesses, but it doesn’t include subtractions for itemized deductions such as mortgage interest and charitable gifts, or personal exemptions.

The new levy is complex, but in effect it is a flat tax on investment income above the $250,000/$200,000 threshold. Note that while the tax applies only to investment income above the threshold, other income—such as wages or Social Security—can raise adjusted gross income, making investment income more vulnerable to the tax. (See the examples below.)

How is “investment income” defined?

Absent guidance from the IRS, experts believe the tax applies to dividends; rents; royalties; interest, except municipal-bond interest; short- and long-term capital gains; the taxable portion of annuity payments; income from the sale of a principal home above the $250,000/$500,000 exclusion; a net gain from the sale of a second home; and passive income from real estate and investments in which a taxpayer doesn’t materially participate, such as a partnership.

The tax doesn’t include payouts from a regular or Roth IRA, 401(k) plan or pension; Social Security income; or annuities that are part of a retirement plan. Also not included are life-insurance proceeds; municipal-bond interest; veterans’ benefits; Schedule C income from businesses; or income from a business on which you are paying self-employment tax, such as a Subchapter S firm or a partnership.

What are some examples of when the tax would and wouldn’t apply?

Example 1: A married couple filing jointly has $400,000 of adjusted gross income—$240,000 of wages plus $160,000 of investment income composed of interest, dividends and net gains from the sale of raw land. Because they have $150,000 of investment income above the $250,000 threshold, they would owe an extra 3.8% of that amount, or $5,700, in tax.

Example 2: A retired couple filing jointly has no wages but does have taxable IRA payouts of $100,000, plus pension and Social Security payments totaling $60,000. They also have dividends and taxable interest of $40,000, plus $40,000 from the sale of two investments. They owe nothing, because their income is below the $250,000 threshold.

Example 3: A single taxpayer earns $60,000 of wages but nets a windfall of $180,000 from the sale of a long-held investment. Because she has $40,000 of investment income above $200,000, she owes $1,520 of extra tax.

Example 4: A single taxpayer has income of $220,000, but all of it comes from Social Security benefits and pension and regular IRA payouts. None of the income is subject to the 3.8% tax.

How would the 3.8% tax apply to the sale of a principal residence?

It would apply if the net gain on the sale exceeds the $500,000 exclusion for joint filers ($250,000 for singles) and the taxpayer’s income also exceeds the adjusted gross income threshold.

For instance, suppose a couple bought a residence long ago for $100,000 in a high-cost city such as New York or San Francisco. In 2013, when they have wages of $100,000, they sell the home for $1.5 million. After subtracting the $100,000 cost of the home and the $500,000 exclusion, they have investment income of $900,000. That plus their wages puts them $750,000 over the $250,000 AGI limit, and they would owe $28,500 in extra tax.

If, however, a single person bought a house many years ago for $50,000 and sells it for $350,000 next year, after subtracting the $50,000 cost and the $250,000 exclusion, the investment income is $50,000. If this taxpayer has $150,000 or less of other income, no extra tax will be owed. But if he earns $150,000 of wages and has $20,000 of dividends and interest, then he would owe extra tax on $20,000, or $760.

What happens if a taxpayer has adjusted gross income above the threshold that is then reduced by a large itemized deduction—such as for medical expenses or a charitable gift?

The tax still applies.

For instance, an elderly taxpayer has adjusted gross income of $225,000 from interest, dividends, pension, taxable IRA payouts and Social Security, including $25,000 in interest and dividends. A combination of charitable gifts and deductible medical expenses nearly wipes out the taxpayer’s taxable income. Still, the taxpayer would owe 3.8% tax on the $25,000 above $200,000, or $950.

Does the 3.8% tax apply to trusts and estates?

Yes, according to Kogod’s Mr. Kautter. The tax applies to net investment income of more than about $12,000 that isn’t paid out to heirs or beneficiaries.

Doesn’t the health-care law also have an extra payroll tax for higher earners?

Yes, and it is historic because it adds a progressive element to what has always been a flat tax. The change raises the Medicare tax by 0.9% (from 1.45% to 2.35%) on wages and self-employment income above $250,000 ($200,000, single). Unlike Social Security taxes, the Medicare tax is uncapped. The new levy has no deductible component for self-employed taxpayers.

For example, each partner in a married couple earns $150,000. Currently, each owes 1.45% of Medicare tax—$2,175—and their employers owe a matching amount. In 2013, the couple will owe another 0.9% on $50,000, or $450. The employer isn’t responsible for withholding it.

Got all that? The new rules present big challenges for taxpayers. But if you start thinking about them now, at least you can minimize the damage.